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Finding value in private debt - U.S. paper

Adoption of private debt is widespread, but we believe many are failing to exploit the full breadth of the asset class.

Inwestycje

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October 16, 2018

This paper explores key principles we believe should guide investors when looking to make attractive returns in private debt and also shares investment examples.

From a brand new opportunity to a core asset class

In 2015 Willis Towers Watson highlighted the opportunity to
play the role of “good bank” in private debt markets in the
article “Illiquid credit – playing the role of a (good) bank.”
Until this point, adoption by institutional investors had
been fairly muted. Fast forward to 2018 and we believe
investors are now increasingly familiar with private debt,
with adoption more widespread — as illustrated by record
levels of new fundraising. According to Preqin1, assets
under management were $638 billion by June 2017, up
from $205 billion at year-end December 2007, making it a
significant part of the credit landscape. We feel the asset
class is simply too big and too important to ignore.
However, with the market increasingly diverse and growing
rapidly, it is not easy to understand its complexities. This is
why we believe the majority of institutional investors have
concentrated their activities in mid-market corporate direct
lending. We feel this approach is much too constraining.

Corporate direct lending was a sensible first
step into the asset class, but can better value
now be found elsewhere?

We continue to advocate for an approach that looks to
exploit the full breadth of private debt markets and is
sufficiently flexible to direct capital towards areas seeking
to offer the most attractive risk-adjusted returns. With
mid-market direct lending now demonstrating signs of
material deterioration in credit underwriting and future
return potential, we anticipate that greater diversity and a
keen focus on finding value will be the key determinants of
success or failure over the coming years.
At its simplest, we are looking to identify borrowers in
private debt markets with a genuine and credit-positive
need for our clients’ capital. And, in addition, we are seeking situations where there are greater barriers to entry for providers of debt capital like us.

This paper explores key principles we believe should guide
investors when looking to make attractive returns in private
debt and also shares investment examples.

Value-generating themes

In reflecting on our investments over the last few years,
we found four common themes: 1) we liked the assets we lent
against; 2) the borrowers needed our capital; 3) there were
barriers to entry for new market entrants; and 4) we made
sure the investment warranted sacrificing liquidity. What do
these mean in practice?

1. Like the assets you lend against

We bias our private debt investments towards lending
in markets with positive market dynamics that support
asset prices. Simply put, we believe assets that are both
strongly underpinned and have a good chance of growing
in value are much more likely to ensure you’ll get your
money back. Clearly there will be exceptions (e.g., lending
to stressed companies or assets with exceptional yields
that appropriately compensate for the risk taken). However,
for the core of our clients’ portfolios, we want to lend to
creditworthy borrowers and assets.

So when trying to filter through opportunities, we believe
it is important to understand the market fundamentals for
the assets you lend against. Lending in a market that you
believe is trading at questionable valuations should give
you pause for thought. By way of example, our research
colleagues in private markets have a negative view on
valuations in large-cap private equity and, consequently, we are biasing capital towards lending in other areas.

2. Lend where your money is genuinely needed

To state the obvious, it makes sense to identify where
regulation and other impediments have diminished credit
availability. The most attractive returns are likely found
where these forces are most extreme and the supply and
demand of capital are unbalanced.

We continue to advocate for an approach that
looks to exploit the full breadth of private debt
markets and is sufficiently flexible to direct
capital towards areas seeking to offer the
most attractive risk-adjusted returns.

Speaking first to regulation, “bank disintermediation”2 has
driven the growth of private debt since 2010. Some eight
years later regulation continues to inhibit traditional lenders.
In all the opportunities we have committed capital to,
regulation has been a key driver in creating the opportunity
for institutional investors.

It is not just regulation that impedes capital flows into a
market. Complexity, illiquidity and the absence of a long
track record in an institutional setting can also be inhibiting
factors. We have found that many investors are unwilling to
be a first mover back into markets that have experienced
performance issues in the past, even if the dynamics in that
market have changed substantially. For those willing to bear
these risks, we believe the rewards can be substantial.
Residential mortgage-backed securities are a great
example of this behavioural bias. It took a significant
period of time for this market to rebound post-crisis from
negative investor sentiment, despite what we believed to be
improving economic fundamentals that resulted in excellent
performance on an outright and risk-adjusted basis for
those brave enough to reenter the asset class early.

3. The easier it is to scale, the less attractive
it is likely to be

We believe institutional investor demand is often heavily
influenced by visibility. More visible investment ideas are
more likely to be considered by institutional investors.
Asset managers, particularly the larger ones, play an
influential role in creating and improving visibility. These
asset managers will often focus on ideas that are simple
to raise, scalable and profitable to run, which means they
tend to crowd towards similar opportunities. As mid-market
direct lending or, indeed, private equity illustrate, large
capital flows can create downward pressure on returns and upward pressure on risk.

As such, we spend much of our time looking for
opportunities too small for others to want to compete.
This can occur either via specialists, often smaller asset
managers, or by encouraging a larger asset manager to
create a smaller, targeted fund around an opportunity
that currently sits within a much broader fund. We believe
this bias towards a smaller specialist is particularly well
rewarded in periods of market complacency and higher
valuations, characteristics we observe in most credit
markets today.

4. Help ensure market returns are fair or better than the risks warrant

You should only invest in private debt if you believe the
returns warrant giving up liquidity. This is not always the
case, as we believe at various points in the cycle the
illiquidity premium may be smaller or greater, and investors
should always aim to compare illiquid opportunities against
a liquid comparable. Willis Towers Watson measures this
via an illiquidity premium index, shown in Figure 1. As the
index illustrates, we believe the illiquidity premium today
is low, suffering from a market flush with liquidity and
yield-starved investors. We are therefore very selective in the new investments we make.

Figure 1. Willis Towers Watson illiquidity premium

Finally, we have purposely used the phrase “market returns”
here to highlight that market participants cannot sustainably
charge borrowers more than the market. So rather than rely
solely on manager outperformance, we look to find markets
where the supply and demand of capital are identifiably
mismatched, creating attractive market returns.

How to find value in surprising places

It’s a challenge to find opportunities that meet all these
requirements. However, using them as a framework has
helped us find value in surprising places.

Opportunities to support poorly served borrowers
in the U.S. residential mortgage market

The U.S. residential mortgage market is one of the largest
and best-followed credit markets globally, so it seems
difficult to believe there are poorly served borrowers. It is
a market we view positively (Figure 2), with asset values
supported by the prosperity of the U.S. consumer, positive
demographic trends, improving economic fundamentals and
the slow recovery of new residential construction post-crisis.
Additionally, we believe poor pre-crisis lending practices have
caused distress for many legacy lenders in this market, and
all have faced meaningful increases in regulation.

Figure 2. U.S. residential mortgage market

We are particularly attracted to the nonqualified mortgage
segment. A qualified mortgage is one that meets specific
U.S. federal government standards and is presumed to have
met the “ability to repay” rule. We believe there is ample
capital for this type of mortgage financing. For those unable
to achieve qualified mortgage status, mortgage providers
have tightened credit standards dramatically, and availability
has been greatly reduced, as illustrated by the decline in
product risk in Figure 3.

Figure 3. Default risk taken by the mortgage market, 1998Q1 – 2017Q3

We feel the opportunity exists in distinguishing credit-starved
borrowers that are genuinely deserving, for example, those
that are self-employed, may be of lower (but improving)
credit quality or those that have missed a mortgage payment
historically but subsequently improved their credit profile.
For these borrowers, we are simply looking to fill a need
created by the borrower’s inability to get a regular bank
or agency mortgage.

To be clear, there is risk associated with nonqualifying
mortgages. However, we believe they do not represent
the reincarnation of the 2006 – 2008 subprime
mortgage market. Rather, nonqualifying mortgages
may present an opportunity for a highly discerning
buyer to potentially achieve attractive risk-adjusted
returns, with positive tailwinds for the U.S. mortgage
market and regulatory-linked barriers to entry.

U.K. real estate bridge lending

Figure 4. U.K. commercial real estate market

The U.K. commercial real estate market is also a large
and well-followed market attracting substantial amounts
of capital, particularly in London and the South East.
While there are some potential headwinds, we believe
regulation has created opportunities in two specific ways.
First, regulation has greatly increased the cost of capital
for bank lending against property, encouraging them to
reduce the loan-to-value ratios and reducing the incentive
to lend against non-income producing property (Figure 5).
Second, in 2013 the U.K. government introduced “permitted
developments rights” that allowed for much more
straightforward office-to-residential conversion approval
and made this regulation permanent in 2015. This had
the desired effect of encouraging office-to-residential
conversion and, in the process, helped support commercial
property valuations by taking supply off the market.
These factors have created a highly attractive opportunity
to provide short-term lending against non-income producing
commercial real estate at a meaningful yield premium.
While we are cognisant of the potential for market dislocation
in London commercial real estate, the short maturity (less
than 12 months) of these loans, the reasonable loan-to-value
ratio and being the senior lender (first mortgage) on the
underlying property all help limit the risk associated with a
market correction.

Figure 5. Reduction in commercial property lending by banks in the U.K.

Conclusions

Private debt continues to offer meaningful return pick up
and strong value for risk taken for those investors willing
and able to go the extra mile and unearth interesting
opportunities. In recent years we believe meaningful
investor capital has flowed into the private debt market,
making it more challenging to find value today. However,
we feel there is value to be found if investors remain
selective, using their precious illiquidity budget to focus
on opportunities where:

The market has attractive tailwinds supporting asset prices

There are regulatory and other impediments reducing capital inflows

It is difficult to scale the opportunity, which reduces competition

The market appears to offer attractive compensation for the risk assumed, rather than relying on manager skill to compensate for an unattractive market beta

As discussed in “Illiquid credit – playing the role of a (good) bank”, we believe a focus on specialist managers is likely
to be well rewarded as returns in core markets are eroded.

Keeping these principles in mind, we believe there are
significant opportunities that remain for investors within
the private debt market. As the search for yield continues
in a low-interest-rate world (but with looming rate, policy
and political risks on the horizon), private debt can play a
valuable role in diversifying an investor’s risk and accessing
more attractive sources of potential return.